Yes, Germany Might Boost Inflation. Here's How

The Financial Times reports today that Germany’s central bank, the Deutsche Bundesbank, “has signaled it would accept higher inflation in Germany.” The newspaper story says this would be “part of an economic rebalancing in the euro zone that would boost the international competitiveness of countries worst hit by the region’s debt crisis.”

This leads to two questions: Is it true, and how could it happen?

The answer to the first question is, yes, it’s true, and it’s not even particularly surprising. Not enough to justify making it the main story on the front page. ”Of course, the Bundesbank is stating the obvious,” Christian Schulz, senior economist in London at Berenberg Bank, Germany’s oldest bank, wrote me today in an e-mail.

What’s obvious is that with other countries, such as Greece, sliding into deep recessions with falling prices, the only way the euro zone as a whole can stick to its inflation target is for the stronger countries, such as Germany, to permit inflation rates above the euro zone average. The European Central Bank sets a medium-term goal of under but close to 2 percent per year for inflation in the euro zone as a whole.

“It’s simple arithmetic,” says Kermit Schoenholtz, director of the Center for Global Economy & Business at New York University’s Stern School of Business.

So that’s the math. The second question is how one country can have higher inflation than another if they share a single currency.

Easily. Even different parts of the U.S. have different rates of inflation. For example, prices are rising faster in North Dakota these days because of the influx of people and machinery to extract oil and natural gas. Inflation differentials are bigger and more persistent in Europe than in the U.S. because the barriers within the euro zone are higher than the ones in the U.S. “dollar zone.” Labor, for example, doesn’t move as easily across national borders to places where wages are higher, so wages can get stuck at uncompetitive levels (as in, say, Spain).

For years, Germany had lower inflation than the likes of Greece, Portugal, and Spain. That was because the peripheral economies were growing rapidly and businesses were careless about keeping a lid on costs. Germany grew at a healthy clip as well but focused relentlessly on improving productivity, so its costs rose more slowly. That’s why Germany’s economy is far more competitive today.

“If the euro area is going to hang together over the long run, you have to undo those competitiveness gaps that have been created,” says Schoenholtz. The peripheral countries need to lower their prices relative to Germany’s. If Germany had very low inflation, those countries would require outright deflation, which is extremely painful. If Germany accepts somewhat higher inflation, primarily via more generous wages to workers, the rest of Europe can have a low but still positive inflation rate.

Says Schoenholtz: “To anybody who’s a monetary economist, this isn’t news.”

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